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Attorney Issues Call to Action Re: Proposed 5% Distribution Requirement for Certain Supporting Organizations
In this opinion article, attorney Bruce Givner reviews the legislative history of a portion of the Pension Protection Act of 2006 which requires Treasury to promulgate new regulations on payments required by Nonfunctionally Integrated Type III Supporting Organizations, why he believes a 5% minimum distribution requirement is an incorrect reading of congressional intent, and how he believes charities should respond.
By Bruce Givner
Background. Following is a small portion of the history that resulted in the enactment of the charitable provisions of the Pension Protection Act of 2006.
2004 Hearing. On June 22, 2004, the United States Senate Finance Committee held a hearing entitled “Charity Oversight and Reform: Keeping Bad Things from Happening to Good Charities.” The featured witnesses included the Commissioner of the Internal Revenue Service (“IRS”) and the President Emeritus of Harvard University. Failings in the enforcement of the existing charitable laws were discussed and recommendations for the future, e.g., changes in IRS Form 990, were made. At that point, supporting organizations were not yet in the cross-hairs.
2005 Letter. On February 3, 2005, Senators Max Baucus and Charles Grassley, the Chairman and Ranking Member of the Senate Finance Committee, respectively, wrote a letter to Secretary of the Treasury John Snow in which they expressed concern “about section 501(c)(3) charitable organizations avoiding private foundation rules by claiming public charity status as a Type III supporting organization (SO) under section 509(a)(3) of the Code and section 1.509(a)-4(i) of the Treasury regulations.” They cited one supporting organization which only made a “payout of approximately .3%.” They noted that “In contrast, a private foundation is generally required to payout 5% of the value of its noncharitable use assets annually….” They concluded by “strongly encourag[ing] the Department of Treasury to revisit the regulations that have created the Type III supporting organizations.”
2005 Article. On April 25, 2005, a New York Times article entitled “A Tax Benefit for Big Donors Often Bypasses Idea of Charity” described how “George B. Kaiser, a publicity-shy oilman who built a fortune estimated at $4 billion by snapping up busted petroleum businesses in Oklahoma, set aside roughly $1 billion for charitable endeavors from 2000 to the end of last year.” However, “only $3.4 million of the money he set aside has gone to charities. The rest is sitting in an obscure philanthropic entity called a supporting organization, so named because it is created to support a specific charity or charities.” The article went on to quote Senate Finance Committee Chairman Senate Grassley: “I'm deeply disturbed that with a good number of supporting organizations, people are taking multimillion-dollar tax deductions for what they claim are contributions to charity, yet too often the result is a thimbleful of benefit to charity."
Distribution Requirement. On August 17, 2006, the President signed Public Law 109-280, the massive Pension Protection Act of 2006. Section 1421(d), entitled “Payout Requirements For Type III Supporting Organizations,“ provided, in relevant part, as follows:
“(1) In General. The Secretary of the Treasury shall promulgate new regulations under Section 509 of the Internal Revenue Code…on payments required by type III supporting organizations which are not functionally integrated type III supporting organizations. Such regulations shall require such organizations to make distributions of a percentage of either income or assets to supported organizations…to ensure that a significant amount is paid to such organizations.”
Definition. A new subparagraph was added to the Internal Revenue Code (“IRS”) to supply the key definition:
“Section 4943(f)(5)(B) Functionally Integrated Type III Supporting Organization. The term `functionally integrated type III supporting organization’ means a type III supporting organization which is not required under regulations established by the Secretary to make payments to supported organizations (as defined under section 509(f)(3)) due to the activities of the organization related to performing the functions of, or carrying out the purposes of, such supported organizations.”
The ANPRM. On August 2, 2007, the Treasury and the IRS issued an Advanced Notice of Proposed Rulemaking (ANPRM). Reg-155929-06, 72 FR 148. Among other interesting points, the ANPRM proposed a distribution requirement for all Type III supporting organizations. For functionally integrated type III supporting organizations it was to be an expenditure requirement similar to that in Section 4942(j)(3)(A) for private operating foundations: substantially all of the lesser of (a) its adjusted net income or (b) five percent of the aggregate fair market value of all its assets (other than assets that are used, or held for use, directly in supporting the charitable programs of the supported organizations) directly for the active conduct of activities that directly further the exempt purposes of the organizations it supports. For non-functionally integrated type III supporting organizations it was to be five percent of the fair market value of its assets (other than assets that are used, or held for use, directly in supporting the charitable programs of its supported organizations).
The Proposed Regulations. On September 24, 2009, the IRS issued proposed regulations regarding the requirements to qualify as a Type III supporting organization. REG-155929-06, 74 FR 184.
Functionally Integrated Type III Supporting Organizations. In the Background discussion of the Integral Part Test, the IRS described how several “commentators argued that the ANPRM’s expenditure test [for functionally integrated type III supporting organizations] was arbitrary and that Congress did not authorize the Secretary to impose a payout requirement on functionally integrated organizations.” Those comments and others apparently had an impact because the Treasury Department and the IRS did not incorporate the expenditure test for functionally integrated type III supporting organizations in the proposed regulations.
Nonfunctionally Integrated Type III Supporting Organizations. Similarly, in the Background discussion of the Integral Part Test, the IRS described how “Many commentators said that [the proposed 5%] payout rate was too high and would erode an organization’s assets over time.” Despite those and similar comments, the Treasury Department and the IRS incorporated the five percent payout rate in the proposed regulations.
Deadline. The September 24, 2009, Notice of Proposed Rulemaking indicates that “Written or electronic comments and requests for a public hearing must be received by December 23, 2009.” [italics in original].
Internal Revenue Service Outreach. One of the two IRS officials listed in the Notice is a skilled public speaker and has been repeatedly available to the professional community to explain the government’s thought process behind the Proposed Regulations. Both during the November 10, 2009, American Bar Association Section of Taxation Exempt Organizations Committee CLE Teleconference, and on November 19, 2009, at the 13th Annual Western Conference on Tax Exempt Organizations, he emphasized that the IRS welcomes comments on all aspects of the Proposed Regulations. (For your convenience, his business card reads: Philip T. Hackney, Senior Technician Reviewer, Office of the Chief Counsel of the Internal Revenue Service (Philip.firstname.lastname@example.org).) However, his responses to numerous questions make it plain that the five percent payout requirement for nonfunctionally integrated type III supporting organizations will remain.
Damage From the Five Percent Payout Requirement For Nonfunctionally Integrated Type III Supporting Organizations. The most obvious damage from the payout requirement for type III nonfunctionally integrated type III supporting organizations is the one voiced by “Many commentators” and quoted above: that it “would erode an organization’s assets over time.” Assume a supporting organization has $1,000,000 of assets and earns 4%, but pays out 5% and has a 1.5% expense factor. Its endowment will be reduced by approximately 25% in a decade. The less obvious damage from the payout requirement is that donors are likely to form fewer type III supporting organizations: why should donors subject themselves to a five percent payout requirement on top of the lack of control and other type III supporting organization restrictions? Why not establish a private foundation and, at least, have dictatorial control over the organization and the ability, each year, to spread the distributions among many, and different, donees? That result will be the damage forecast by commentators quoted in the Notice: supported organizations will not receive “the kind of consistent, reliable, long-term support [they] have come to expect.”
The Action By The Internal Revenue Service Is Illogical And Unwarranted. The IRC imposes a five percent payout requirement on private foundations. IRC Section 4242. Had Congress wanted to impose that five percent payout requirement on nonfunctionally integrated type III supporting organizations, Congress could have amended the IRC to impose that requirement. After all, the Pension Protection Act of 2006 had about one hundred pages concerning non-pension issues. In fact, that Act made numerous changes in Section 4942 itself. So why would Congress leave such a major change to the IRS? The answer is that Congress did not and, to the extent that the IRS has taken it upon itself to do so, its action is unwarranted. However, as we know all too well, logic and the tax laws are not a happily married couple.
Also, despite this author’s strong feelings, the Proposed Regulations would almost certainly prevail over a taxpayer’s challenge in court. To apply what former IRS Commissioner Donald Korb has written to these facts, Congress directed the IRS to issue a payout percentage, and when the IRS fills a gap reasonably, the Supreme Court has consistently ruled that courts must defer to and uphold its interpretation. “The Four R's Revisited: Regulations, Rulings, Reliance, And Retroactivity In The 21st Century: A View From Within,” Donald L. Korb, 46 Duq. L. Rev. 323 (Spring, 2008).
Policy Reason To Distinguish Between Nonfunctionally Integrated Type III Supporting Organizations And Nonoperating Private Foundations. The Background to the Proposed Regulations cited commentators who noted that supporting organizations are designed to provide “long-term consistent support to specific organizations, while private foundations may pay out to whomever they choose.” Also, some commentators noted that “a supporting organization maintains a governance relationship with its supported organization(s) in a way that a private foundation does not.” Those are policy reasons to impose the higher distribution requirement on nonoperating private foundations and, of course, those policy reasons are embodied in the statute, insofar as Section 4942 does not apply to supporting organizations.
Recommended Revision To The Proposed Regulations. Congress charged the IRS to come up with a solution to a problem. The IRS came up with the wrong solution by applying an IRC section, a solution available only to Congress itself. However, several decades ago the IRS came up with a solution for a similar situation, and Congress is aware of and has obviously acquiesced in that solution. As we know, operating public charities generally are not subject to a minimum activity level requirement. However, one category of public charity effectively has an expenditure requirement: a medical research organization described in §170(b)(1)(A)(iii). The IRS requires a medical research organization to either spend 3.5% of its endowment or devote more than one-half of its assets to further its research activities to meet the safe harbor requirement of Regs. §1.170A-9(d)(2). That 3.5% distribution requirement would be – for nonfunctionally integrated type III supporting organizations - the “Goldilocks” solution.
Related Problems With The Proposed Regulations. Although the five percent distribution requirement is the most obvious problem with the Proposed Regulations, there are related problems. These related problems are primarily caused by the fact that the IRS decided not to incorporate IRC Section 4942 by reference, but to invent another series of rules. Therefore, the new rules lack some important features needed for any distribution requirement, e.g., set-asides. See Internal Revenue Code Section 4942(g)(2).
Call To Action. It seems unlikely that the IRS will drop the five percent distribution requirement from the Proposed Regulations solely due to an appeal based on (i) logic, i.e., the structure of the IRC, and (ii) what is in the best interests of public charities and their supporting organizations. Therefore, charities must now contact their elected public representatives, and demand that they send letters to the IRS clarifying that it was not Congress’ intent to apply Section 4942 to public charities.
Conclusion. The five percent distribution requirement for nonfunctionally integrated type III supporting organizations in the Proposed Regulations is (i) an incorrect reading of the intent of Congress and (ii) bad policy. The charitable community must act now through its representatives in Congress, before the Proposed Regulations become final. Although the official comment period ends on December 23, 2009, the IRS has unofficially, graciously indicated that it will welcome comments into the Spring.